Private credit

Private credit is an asset defined by non-bank lending where the debt is not issued or traded on the public markets. Private credit can also be referred to as "direct lending" or "private lending". It is a subset of "alternative credit". Private Credit has been one of the fastest-growing asset classes. According to Prequin, private credit more than tripled between 2007 ($205B) and 2018 ($638B). Just in 2017, private debt fundraising exceeded $100B. One factor for the rapid growth has been investor demand. Returns have averaged 8.1% IRR across all private credit strategies, and some strategies have yielded as high as 14% IRR. At the same time, supply has increased as companies have turned to non-bank lenders after the financial crisis due to stricter lending requirements.

Big picture, private credit can be grouped into two strategies: capital preservation or return maximization. Capital preservation strategies seek predictable returns while protecting against losses. Capital preservation investment strategies are strategies such as senior loans to well capitalized and profitable companies. Senior loans are the most senior in the capital structure and have the highest likelihood of being repaid in case the company has financial troubles. These strategies are defined by predictable returns with a low default rate. Return optimizing strategies such as distressed debt focus on return maximizing. These strategies have much more uncertain returns and higher instances of default. Finally, there has been the rise of niche strategies like aviation financing.

Historically, capital for private credit funds has come from institutional investors and focused on leveraged buyouts. In particular, these funds provided the capital to fund the capital gap between the purchase price and the LBO firm's equity and the bank financing. Normally, capital came as senior debt, subordinated debt, and mezzanine debt - depending on the particular investment. However, private credit now has expanding to sponsorless deals (where the firm takes on debt without equity), purchase of non-performing debt from commercial banks, specialty strategies such as aviation finance, and consumer/small business financing platforms. Additionally, many companies now opt for private credit over publicly issued high yield.

In addition to private funds, much of the capital for private debt comes from business development companies (BDCs). BDCs were created by Congress in 1980 as closed-end funds regulated under the Investment Company Act of 1940 to provide small and growing companies access to capital and to enable private equity funds to access public capital markets. Under the legislation, a BDC must invest at least 70% of its assets in nonpublic US companies with market value less than $250M. Moreover, like REITs, as long as 90% or more of the BDC’s income was distributed to investors, the BDC would not be taxed at the corporate level. While BDCs are allowed to invest anywhere in the capital structure, the vast majority of the investment has been debt because BDCs typically lever their equity with debt (up to 2X their equity), and fixed income investing supports their debt obligations.

For non-institutional investors looking to invest in private capital, few options exist because most of the investment vehicles are private and limited to qualified investors ($5M or more liquid net worth). That being said, investors can invest in publicly-traded BDCs and closed end fund focused on private credit. The only ETF in the asset class is the Virtus Private Credit Strategy ETF (Ticker: VPC), which an index ETF of BDCs and publicly traded closed-end funds focused on private credit.